Unchecked Australian dark pools could be “detrimental”

The growth in dark pools in Australia could prove to be
“detrimental” to the market if left unchecked by regulators, according to an
Australian think tank. Alex Frino, chief executive officer of the Capital
Markets Cooperative Research Centre (CMCRC) in Sydney, has called on regulators
to be more proactive in dealing with the growth of dark pools.

The call comes as the Australian Securities and Investments
Commission (ASIC) goes into consultation on market structure reforms intended
to strengthen market integrity, which focuses on such areas as extreme price
movements, enhanced data for market supervision and pre-trade transparency.
ASIC’s position is that it will not look into regulating dark pools until the
size of the market trading ‘in the dark’ reaches roughly double the level it
was in mid-last year.

“[ASIC has indicated it] will keep reviewing the marketplace
to see what developments arrive and be reactive,” said Frino. “I’d like to see
them be more pro-active.”

Frino’s team has been working on applying research from
Rutgers University, New Jersey, to Australian markets and found that the
increasing size of dark pool market share will push up the cost of trading on
lit exchanges. Their conclusion was that if 20% of the Australian market were
to go dark, there would be an incremental cost increase for lit trading of one
basis point – three times the ASX’s exchange fee.

Frino noted this was in addition to the liquidity problems
of fragmenting a relatively small and less liquid Australian market.

“If you look at the Nasdaq, the turnover of the top five
stocks is three US$3 trillion – that’s already fragmented. The turnover of the
entire Australian market is about US$1 trillion. If you start fragmenting it,
you’re going to have a serious impact on the marketplace,” he said.

Currently around 5% of the Australian market trades on dark
pools.

However, the CMCRC’s Frino has this week revised up his
estimates for how much of the Australian market could eventually go dark – from
30% to 50%. According to Frino, around 30% of the US trades in the dark. In
liquidity terms, the bottom half of the 7,000 stocks listed in the US, dark
pool trading in any individual stock trading averages around 50%.

“If we see the same thing in Australia, it will be highly
detrimental to the marketplace,” said Frino. “I’m concerned about stocks where
the dominant form of trading is done in the dark – I think that’s a serious
problem for price discovery.”

Frino is still in the process of investigating why some investors
turn to the dark pools for trades, but he says it can be related to the cost of
a trade.

“Market participants believe they can get price improvement
relative to the lit market by going to the dark. But when you execute the trade
in the dark, you’re getting price improvement on a deteriorated lit marketplace.
I don’t think you get overall price improvement.”

Frino said one measure he would like to see reintroduced in
Australia is a threshold minimum trade size, above which trades can be executed
in the dark but below which must stay lit. This rule was effectively dismantled
in 2011 on the launch of Chi-X Australia. Likewise, London had similar limits
but has also recently removed them. The negative impact of dark pools is not
limited to Australia, says Frino, who notes that other small markets in Asia
Pacific and elsewhere could also see price rises and liquidity problems. He
said even London, given their lower levels of turnover relative to the US,
could face negative impact from dark pool trading.